Understanding Financial Statements

Lyn M. Fraser, Aileen Ormiston

Chapter 5 A Guide to Earnings and Financial Reporting Quality - all with Video Answers

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Chapter Questions

Problem 1

________ When should revenue be recognized, assuming generally accepted accounting principles are followed?
(a) Revenue should be recognized when cash is collected from the customer.
(b) Revenue should be recognized based on the company's individual policy.
(c) Revenue should be recognized when delivery of products or title to those products has passed to the buyer or services have been rendered and the price has been determined with the expectation of collection.
(d) Revenue should be recognized when a contract has been signed that details the date and time that the product will be delivered or the services rendered and the price has been determined.

Puneet Prajapati

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Problem 2

________ Which of the following is a technique for boosting revenues?
(a) Follow the "35-day month practice" in which the books are kept open longer than the month end in order to record extra sales.
(b) Record transactions at the net amount.
(c) Delay shipment of goods.
(d) Increase the allowance for doubtful accounts.

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Problem 3

________ Why is it important to analyze the relationship among sales, accounts receivable, and the allowance for doubtful accounts?
(a) Comparing the three accounts' growth rates is the only way to determine if the firm is using vendor financing.
(b) The allowance for doubtful accounts is a reserve account that can be used to manipulate the earnings number.
(c) Price and volume changes will cause the relationship among the three accounts to be volatile.
(d) It is important to determine if the three accounts are changing with the inflation rate.

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Problem 4

________ Where can information about sales price and volume changes be found?
(a) On the face of the income statement.
(b) In the notes to the financial statements.
(c) On the balance sheet.
(d) In the management's discussion and analysis.

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Problem 5

________ Which method of inventory is generally thought to produce the highest quality of earnings?
(a) FIFO.
(b) LIFO.
(c) Average cost.
(d) All of the above.

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01:14

Problem 6

________ When does a base LIFO layer liquidation occur?
(a) A base LIFO layer liquidation occurs during a deflationary environment.
(b) A base LIFO layer liquidation occurs when companies are shrinking rather than increasing inventories after a period of inflation.
(c) A base LIFO layer liquidation occurs when a company switches from the FIFO to the LIFO method of inventory valuation.
(d) A base LIFO layer liquidation occurs when a firm increases inventories after a period of inflation.

Adriano Chikande

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Problem 7

________ How does the recording of fulfillment costs cause a quality of financial reporting issue?
(a) Many companies record fulfillment costs as operating expenses when they should be recorded as miscellaneous expenses.
(b) Bad debt expenses are recorded as fulfillment costs.
(c) Fulfillment costs can include items that are properly classified as cost of goods sold, as well as other operating costs, therefore causing a comparability issue when comparing firms' gross profit and operating profit margins.
(d) Fulfillment costs cause the operating profit margin to be wrong.

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Problem 8

________ If a firm has written down the value of their inventory, what should be of concern to the analyst?
(a) The analyst should consider removing the effects of the write-down from the profit margins in order to better compare changes from one period to the next.
(b) The analyst should deduct the loss from the write-down from the net earnings amount.
(c) The analyst does not need to do anything since write-downs of inventory are so frequent.
(d) The analyst cannot determine the effect of the write-down and, therefore, is unable to make any adjustments.

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Problem 9

________ Which of the following expenses is (are) usually considered to be discretionary?
(a) Research and development.
(b) Advertising.
(c) Depreciation.
(d) Both (a) and (b).

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Problem 10

________ Which of the following statements is false?
(a) The straight-line method of depreciation is lower in quality than other methods, in most cases, because it does not reflect the economic reality of product usefulness.
(b) Poor quality of financial reporting results when firms misclassify operating expenses as capital expenditures.
(c) Firms must follow the schedule prescribed by the FASB for determining the lives of long-lived assets.
(d) Analysts can learn about the depreciation policy of a firm by reading the notes to the financial statements.

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01:41

Problem 11

________ What is meant by the term "cookie-jar accounting"?
(a) The abuse that occurs when companies create reserve accounts for the purpose of setting aside funds in good years and then shifting the reserve amounts to the income statement in poor years.
(b) The abuse that occurs when companies use operational funds for nonoperational items such as parties, doughnuts, cookies, and personal travel expenses.
(c) The abuse that occurs when firms acquire another company and then write down the cost of in-process research and development.
(d) The abuse that occurs when firms charge ordinary business expenses as restructuring charges.

Jingchi Yan

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Problem 12

________ Which of the following statements is true?
(a) The quality issues of pension accounting have been largely eliminated by the issuance of FASB Statement No. 87.
(b) If the assumed pension interest rate assumption is lowered, the annual pension cost will increase.
(c) If the assumed pension interest rate assumption is increased, the annual pension cost will increase.
(d) Due to the accounting rules for pension plans, most companies have underfunded pension plans.

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Problem 13

________ Which of the following is not classified as a nonoperating revenue or expense?
(a) Interest income.
(b) Equity income or loss.
(c) Gains or losses on the sales of assets.
(d) Salaries expense.

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Problem 14

________ What information cannot be found in the notes to the financial statements regarding income taxes?
(a) A reconciliation of the United States federal statutory tax rate to the company's effective tax rate.
(b) Year to year changes in deferred tax accounts.
(c) A reconciliation of any foreign statutory tax rate to the company's effective tax rate.
(d) None of the above.

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Problem 15

________ If discontinued operations have been sold, what must be recorded on the income statement?
(a) The gain or loss from operations of the division up to the time of sale, net of tax.
(b) The amount that the buyer paid for the discontinued operations.
(c) The gain or loss from the sale of the discontinued operations, net of tax.
(d) Both (a) and (c).

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Problem 16

________ What must be true for an item to be classified as an extraordinary item?
(a) The item must be both unusual and infrequent in nature.
(b) The item must be either unusual or infrequent in nature.
(c) The item must be registered as extraordinary with the FASB.
(d) The item must be approved as extraordinary by the SEC.

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Problem 17

________ Why would a firm repurchase its own common stock?
(a) The firm believes their stock is undervalued and purchases it as an investment.
(b) The firm purchases stock to be used in employee stock option programs.
(c) The firm is trying to reduce the number of shares outstanding in order to boost the earnings per share amount.
(d) All of the above.

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Problem 18

________ Which of the following statements is false?
(a) If a firm uses operating leases extensively, the analyst should investigate the impact of those leases on leverage ratios.
(b) The analyst should read the "Commitments and Contingencies" disclosures to learn of any off-balance-sheet financing or other complex financing arrangements.
(c) The analyst should assess whether the right type of debt is used to finance assets, i.e., short-term debt is used to finance long-term assets and long-term debt is used to finance current assets.
(d) The analyst should determine the significance of any legal proceedings.

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Problem 19

________ How have companies been able to manipulate the information on the statement of cash flows?
(a) Companies cannot manipulate cash flow information.
(b) Some companies recorded vendor financing transactions as investing, rather than operating activities.
(c) Some companies recorded increases to accounts receivable as decreases to cash flow from operations.
(d) Some companies borrowed money to increase the cash flow from financing activities.

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Problem 20

________ Which earnings number is the most relevant for decision-making purposes?
(a) An earnings number adjusted for items that are not relevant for the decision at hand.
(b) Pro forma earnings.
(c) EBITDA.
(d) Core earnings.

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